There is a battle in politics and the media going on about what the future tax rates should be and whose rate should change. President Obama and Warren Buffet are on the side that believes that the wealthy should pay more for numerous reasons. And there are political opponents who are arguing that no one should pay higher rates, especially wealthy business owners who are presumably the ones who will create the jobs that are the main goal of Obama’s Jobs Bill.

There are people who articulate the politics of this issue well enough that make it unnecessary for me to go into it here. In this article I will discuss how this issue has been misunderstood in the media, and what you should know about it concerning your own finances.

Socialism Vs. Capitalism

Unfortunately, the mass media makes mistakes in how this issue is portrayed. The most common one is that they make a link between income and wealth that isn’t as strong as they believe. There are reams of studies, political papers, and opinion written about how social standing, health care outcomes, etc are determined by your income. It’s deafening. I’ve read many newspaper articles and OpEds over the years that use the idea of income and wealth interchangeably.

People who make large incomes are not necessarily wealthy. What makes someone wealthy is what they own, not what they earn.

This misunderstanding is rooted in the difference between socialism and capitalism. In both economic systems, people earn incomes and how much they earn is determined by skills, experience, and training to varying degrees. However, in a capitalist system, the capital goods such as equity, equipment, financial instruments are generally owned by private entities whereas in a socialist economy they are owned and managed by the collective. In a Socialist system, the fight is on income because no one can own capital assets where the real wealth is.

Warren Buffet made $40M of income that was taxable, yet this is less than 1% of his total wealth. What makes Buffet wealthy isn’t that income it’s the huge stake he owns in his company, Berkshire Hathaway that is over 100X larger than his declared yearly income. Journalists usually make no mention of this either because they don’t understand capitalism or how it works. If one really wanted to tax the wealthy, the right place is to go after their wealth not their income.

Key Takeaways

• Mass media influences public policy and they are generally antagonistic towards people who earn large incomes and muted on true sources of wealth. Focus your efforts on activities to accumulate assets that will make you wealthy. As the balance sheet of Warren Buffet shows his assets are the real story and not his income.
• We live in a mostly capitalistic society so the engines of the economy (including Warren Buffet’s company) are for sale for anyone to own. This is the best way to achieve financial independence, buying assets that will growth and make you money over the long term.
• Don’t concern yourself too much with these battles because the combatants are fighting over issues that are not front and center concerning the ones you need to focus on to achieve financial independence.

Determine Your Personal Wealth Factor

Buffet is one of the richest persons in the world. His income is very small compared to his assets. This naturally leads to determine a method to compare anyone’s wealth to Buffets. This is not a simple total of wealth, but a ratio of your income to your assets. If your assets are large relative to your income and they are growing faster than your income then you are on the right track. Here’s the calculation:

Wealth Factor = ( Assets – Liabilities / Earned Income )

In Buffet’s case, his assets are 40B. It can only be guessed what his actual earned income is, but it is most likely much less than his reported income of 40M because a lot of that is probably unearned, or investment income. According to SEC filings Buffet’s income from Berkshire is only 524K.

For Buffet, his Wealth Factor is 75,000. When calculated for the author, it’s 7. There is a long way to go!

When you invest money in regular taxable accounts (not your 529 college savings accounts, IRAs, 401Ks, or other retirement investment accounts), any money your earn is typically added to your total yearly income for income tax calculation purposes. In this article, I will discuss (3) common types of investments and what taxes will be due.

First, the Good News

No one likes paying taxes, but you are probably not shocked to find out that investors pay less taxes than workers earning income, or sometimes even savers. There are a number of reasons why this is the case.

1.      Public insurance programs (unemployment insurance, Social Security, disability programs, etc) are typically funded from deductions taken from worker salaries. These programs are designed to tie directly to employment. Investing income does not apply, so taxes do not apply.

2.      Legislators have over time given preferential treatment to ‘capital’ since this is the source of job creation.

3.      Investors sometimes pay taxes on investment income in addition to the corporate taxes already paid by the company. The lower investment tax rates try to lessen this double tax impact.

Earning income through investing can therefore off the opportunity to increase your take home pay more than working more hours, because you get to keep more of what you earn.

Next, Capital Versus Investment Income

To understand taxes, you first need to know the difference between capital versus investment income. Capital is the stake that you have in the investment, which is the value of the shares of the company or the total bond value. Capital has historically had the most favorable tax treatment, while investment income has less favorable treatment.

Let’s say you bought $10,000 worth of Johnson and Johnson (JNJ), and you earned $300 in dividends during the year. The total value of your capital is $10,000 (at the time you purchased the shares), and the value of your investment income is $300.

Capital Gains Taxes

Capital gains taxes come into play when you sell your investment. Using the example above, if we sell the JNJ shares for $12,000, a capital gain is realized. If the gain occurred on a short term basis (less than one year), you pay the same rate as your income tax rate. For a long term gain (greater than one year), the lower capital gain rate applies.

On to the investment types. This concerns (3) different types of investment income.

Fully Taxable Income

With a fully taxable investment, you pay your marginal income tax rate. This is the highest rate you will pay, it is the same income tax rate as if you earned additional money by working additional hours. You still pay less taxes because you do not pay any payroll taxes that would be due with work income, you pay just the income taxes.

There are many reasons why an investment would be fully taxable, here are a few:

• The company itself is not required to pay any taxes due to its registration/structure. The most common examples are real estate investment trusts (REITs). The tax burden is passed on to the investor.
• The company does not pay enough corporate taxes for investors to qualify for lower investment tax rates.
• The investment is a bond or bond-like, these generally do not get the lower rates.

Non Taxable Investment Income

Some investments are not taxable at all. The most common examples are municipal bonds, which are issued by local/state governments typically to fund capital projects. If you otherwise have lots of other income, these can lower the amount of taxes you pay because the U.S. Federal Government also exempts these from taxation in addition to the local/state government that issued them.

Note that U.S Treasury bonds/notes are not the same as municipal bonds, they are used to fund the general operations of the federal government. They are fully taxable at the federal level at marginal income tax rates.

Qualified Investment Income

Most common stocks fall into the category of qualified investments (JNJ mentioned above is an example). Holders of qualified investments pay federal income taxes at a lower rate than their working income tax rates. The word ‘qualified’ has a specific meaning, in that the company must follow some rules that show that the company paid enough corporate taxes. Then, the investor gets the lower tax rate.